Tuesday, November 24, 2015

All the doomsaying we heard before the report of the Seventh Pay Commission(SPC) has turned out to be nonsense. The hike in pay is a modest 16%, with a total increase of 23.55 per cent after taking into account allowances and pension. Let me spell out the impact:

Fiscal deficit: The impact on the central government is 0.46% of GDP which reduces to around 0.4% of GDP once taxes are taken into account. A correct way to look at the impact is to amortize this impact over a business cycle. If amortized over, say, five years, the annual impact is a piffling 0.08%

Output and growth: Government spending on pay will rise. Analysts think this will be expansionary as it was during the time of Sixth Pay Commission. They are wrong. On the last occasion, higher pay was allowed to translate into a higher fiscal deficit. This time, the finance ministry has said the targeted reduction in fiscal deficit from 3.9% of GDP in 2015-16 to 3.6% of GDP in 2016-17 will be adhered to. This means that increased pay will be offset by reductions on other accounts. The pay hike will, therefore, not be expansionary

Inflation: For the same reason as above, the pay hike will not have a significant inflationary impact

Sectors: Higher spending by government employees can provide a modest stimulus to sectors such as real estate, consumer goods and automobiles. The stimulus will be modest because the increases in pay are not very large.

The SPC has improved terms for pensioners considerably but the outcome falls short of one rank, one pension. Earlier, retireees used to be placed at the minimum of the new pay bands corresponding to the levels at which they retired. Now, they will be given increments corresponding to the increments they got above the minimum. This is a huge benefit to pensioners.But it's not one rank, one pension. All retired professors don't get the same pay- there will be a difference depending on the number of years for which they served as professor.

Critics of Pay Commissions have said that the tail is government is too long and the head too small. This can change if the government wishes. There will be large retirements in the C and D categories. These can be left unfilled and the government can instead hire in larger numbers at the officer level. In the years ahead, there is a great opportunity to right size the government and bring in diverse skills.

Overall numbers have been growing mainly in the ministry of home affairs (police and paramilitary forces), not so much in most other ministries and departments. The SPC provides data that shows that India's bureaucracy in relation to the population is much smaller than that of the US.

The other criticism of Pay Commissions is that they have not emphasised performance and productivity adequately. The Sixth Pay Commission had proposed a performance-related incentive scheme (PRIS). The SPC notes that it hasn't quite taken off because of numerous operational difficulties. It also notes correctly that performance measurement in government is rather difficult. It is less difficult in the private sector where performance can be measured against defined commercial targets (although even this is done badly in most private firms). The SPC proposes performance related pay linked to a new framework.

My sense is that operationalising this framework will prove just as difficult as the Sixth Pay Commission PRIS. The focus in government should be primarily on collective performance as measured by independent audits, the reports of which are made transparent. There should be penalties for collective under- performance (such as delayed promotions and even compulsory retirement). Financial rewards for good performance should be for a team as a whole and the amounts should be quite modest. Anything else will create havoc in government.

There is a strong case for creating a separate management audit department in the CAG. All government departments, agencies, regulators and autonomous institutions must come under its purview. The management audit should focus not just on outcomes but also on internal processes and governance and should cover HR issues. Where processes and governance are weak, it will be reflected in outcomes. A management audit should capture these before outcomes are undermined.

Friday, November 20, 2015

The attacks on Paris in recent days have raised concerns about the potential impact of such acts on economies and markets. Don't take the prophets of gloom seriously. Terrorism has little impact on the economy. I have always argued thus and was happy to see an article in the FT corroborating my view.

Terrorism involves attacks on some places in a city. The city may shut down for a few days, some economic centres may suffer damage, there could some loss of output. However, this is an insignificant fraction of national output and registers merely as a blip. Terrorism could have some impact on tourism and it could affect foreign investment. But for this to happen, it has to be sustained and widespread. This is not common.

The modern economy has two great strengths. First, it is greatly decentralised. Secondly, growth depends more on knowledge capital, embodied in people and published work, than on physical capital. Both these make for enormous resilience in economies.

The effect of decentralised production was best exemplified in the ability of Germany to maintain production in the face of savage bombing in the dying months of World War II. By spreading out production and thanks to the genius of Albert Speer, the armaments minister in the Third Reich, Germany war production remained not very far from its peak despite daily bombing raids mounted by the Allies. It was not aerial bombing but boots on the ground- and mostly Russian boots- that brought Hitler's Germany to its knees.

In the more modern period, Sri Lanka's economy grew at a brisk pace even when the LTTE's ability to strike was formidable. India itself has known insurgencies in various parts for long spells but this has had little impact on the economy. The 9/11 attack in the US was shrugged off by the markets despite the large damage it caused. The fear at that time was that global economic integration brought about by the spreading out of the production chain would be imperilled. This did not happen. Any risk of terrorism simply gets priced into costs and the premium is not large.

The current bout of militancy is bound to impact migration into the west. But world labour flows have been largely controlled, so the incremental impact will not be much. Over a long time frame, adverse demographics makes greater migration into the west inevitable. The west will be selective about whom it lets in, screening will be tighter but, finally, large flows of people will happen.

More importantly, growth is driven overwhelmingly by increases in efficiency brought about knowledge capital as economist Solow showed decades ago. The destruction of physical capital and even the deaths of large numbers of people does little to degrade the availability of knowledge capital. This was true even in past centuries when marauding conquerors burnt down cities - only for these cities to rise from the ashes. Think also of Somnath being rebuilt umpteen times after the raids by Mohammed Ghazni. If this could happen in the past when knowledge was largely embodied in peiopel, think of the possibilities today when knowledge is diffuse and universally accessible at the click of a mouse.

If wars waged on a titanic scale could not stop the growth of economies, terrorist acts are no more than mosquito bites on the surface of the world economy. We will live in fear, human rights will be encroached upon, the quality of life may suffer. But material well being will not be affected by terrorism. There is, of course, one exception. That is terrorists getting hold of a seriously dirty bomb. We must fear terrorism because of that one possibility. Random attacks, with all the sorrow they cause, the world can take in its stride.

Wednesday, November 18, 2015

A recent decision of the US Supreme Court on insider trading, reported in the Economist, has not received the attention it deserves.

The Court was asked to review a decision of an Appeals court in an insider trading case. The Appeals court had overturned the conviction of two hedge fund managers accused of insider trading. The Supreme Court refused the reivew, which means the Appeals court decision stands.

The Appeals court decision is significant. It ruled that the fact that the recipient had benefited from information (which was the case with the two fund managers) and was a friend or family member of the recipient was not sufficient to obtain a conviction. It prescribed two standards:

Prosecutors must prove that the provider had a 'direct personal benefit'

Prosecutors must also prove that the recipient was aware that the provider should not have been providing the information and that the provider received a benefit

The two new standards seem to imply that if somebody passes on information that benefits the recipient but not the provider (in a 'direct' way), then it cannot be said to be insider trading. As the Economist points out, a CEO who passes on information that benefits the recipient without the CEO being compensated may avoid prosecution hereafter.

The interesting question that arises is how the case of Rajat Gupta, the former McKinsey head who is serving a jail sentence currently, will come to be viewed. Mr Gupta was not seen to have been compensated directly from the trades that happened consequent to the information he was said to have passed on. Yet, it was held that he had a relationship with fund manager Rajaratnam from which he stood to benefit. Does this constitute insider trading in light of the two criteria now laid down?

Thursday, November 12, 2015

It's never too late for a mea culpa. John Reed, who drove the transformation of Citibank into a universal bank with the merger with the Travelers Group in 1998, now thinks the universal banking model is fatally flawed. He gives two reasons:

One was the belief that combining all types of finance into one
institution would drive costs down — and the larger the institution the
more efficient it would be. We now know that there are very few cost
efficiencies that come from the merger of functions — indeed, there may
be none at all. It is possible that combining so much in a single bank
makes services more expensive than if they were instead offered by
smaller, specialised players.

The second thing we were wrong about has to do with culture — and
this turns out to be very serious. Mixing incompatible cultures is a
problem all by itself. It makes the entire finance industry more
fragile. This is what I mean by an unstable cultural balancing act at
the core of universal banking and, the restructurings and management
changes we are now seeing in European financial institutions.As is now clear, traditional banking attracts one kind of talent,
which is entirely different from the kinds drawn towards investment
banking and trading. Traditional bankers tend to be extroverts, sociable
people who are focused on longer term relationships. They are, in many
important respects, risk averse. Investment bankers and their traders
are more short termist. They are comfortable with, and many even seek
out, risk and are more focused on immediate reward. In addition,
investment banking organisations tend to organise and focus on products
rather than customers. This creates fundamental differences in values.

The first explanation has merit, although Jamie Dimon of JP Morgan would not agree. The second explanation applies to universal banks whose investment banking income is derived mostly from trading activities. It would not apply to universal banks whose investment banking activities have mostly to do with underwriting and advisory work or to banks that are not exposed to non-banking activities such as asset management, insurance, etc because these activities are carried out by independent, affiliate companies in a group (as in the case if HDFC Bank or ICICI Bank).

Thus, the problem is not universal banking per se but the particular model of universal banking that became the norm in the US. The Indian model of universal banking has been very successful indeed because Indian banks' exposure to investment banking is related to merchant banking activities and not to proprietary trading.

Wednesday, November 11, 2015

We are all brought up to think that shareholders are "owners" of a company. John Kay points out in a delightful piece that that is not the legal position. They merely have some rights in the company.

If I own an object I can use it, or not use it, sell it, rent it,
give it to others, throw it away and appeal to the police if a thief
misappropriates it. And I must accept responsibility for its misuse and
admit the right of my creditors to takea lien on it.But shares give their holders no right of possession and no right of
use. If shareholders go to the company premises, they will more likely
than not be turned away. They have no more right than other customers to the services of the
business they “own”. The company’s actions are not their responsibility,
and corporate assets cannot be used to satisfy their debts. Shareholders do not have the right to manage the company in which
they hold an interest, and even their right to appoint the people who do
is largely theoretical. They are entitled only to such part of the
income as the directors declare as dividends, and have no right to the
proceeds of the sale of corporate assets — except in the event of the
liquidation of the entire company, in which case they will get what is
left; not much, as a rule.Of 11 tests of ownership Mr Honoré (a legal scholar)put forward, the relationship betweena company and its shareholders satisfies only two, and these rather minor. Three are satisfied in part; six are not met at all.

Tuesday, November 10, 2015

The people of Bihar have spoken. So have the political pundits who pretend to be able to read their minds. And what do explanations do the pundits have for the verdict? The BJP's brand of intolerance and communal politics will not pay. The RSS chief did great damage with his comments on rethinking caste-based quotas. Nitish Kumar did a great job on the development front. The BJP top brass was arrogant in its dealings with local leaders and this led the latter to switch off. Modi hurt the pride of the people of Bihar with his comments about the DNA of the Bihari. And so on.

Alas, the numbers tell a rather more prosaic story. Two is less than three but two plus two is greater than three. In the 2014 Lok Sabha polls and in the 2010 assembly polls, the JD (U) of Nitish Kumar and the RJD of Laloo Yadav went it alone. In 2015, they formed an alliance. The anti-BJP vote thus got consolidated and translated into a massive win for the Mahaghatbandhan (MGB).

Let's look at the numbers (taken from ET, Nov 9). In 2010, the NDA had a vote share of 23.3%. This rose to 34.1% in 2015, an increase of nearly 11 percentage points. In 2014, the NDA had polled 39.4% of the vote share, so, yes, relative to the peak of 2014, the NDA has seen a decline of around 5 percentage points. The MGB vote share declined from 43.8% in 2010 to 41.9% in 2015. In 2014, the vote share was almost the same as in 2010- 43.5%. Note that the MGB too lost vote share relative to 2014 albeit of only 1.6 percentage points.

A simple reading of the verdict would be:

The MGB is more popular today than the NDA which was also the case in 2010

The NDA has become more popular in 2015 than it was in 2010 and the MGB less so.

Relative to 2014, both the NDA and the MGB are less popular; the decline in popularityof the NDA has been greater.

What about the individual members of the alliances? The JD (U) vote share has fallen from 22.6% in 2010 to 16.8%, so Nitish Kumar is less popular today than he was five years. The RJD vote share is almost intact- 18.84%. and 18.5%. The BJP's vote share has soared by 16.5% in 2010 to 24.6% in 2015 (although there is a decline of 5 percentage points relative to 2014).

What inferences can we draw from these numbers? Well, the following:

Arun Jaitley is right in saying that it was the political arithmetic that is primarily responsible for the BJP's defeat

By having the largest vote share amongst all parties, the BJP has emerged as the leading party in Bihar

But for Laloo Yadav retaining his popularity, the MGB may well have lost
the election. So, it was not Nitish Kumar's development record but
Yadav's caste base that helped the MGB romp home

The decline in BJP vote share relative to 2014, to some extent, reflects the wearing off of the party's sheen in recent months. One can speculate about the factors that have caused this.

The consolidation of the anti-BJP vote is absolutely crucial to the victory of the non-BJP parties. Any rift that emerges will damage the MGB's chances

If the BJP is able to get back to its vote share of 2014- by showing better results on the economy, by playing the Hindutva card more adroitly, etc- its fortunes in Bihar will be very bright indeed.

Friday, November 06, 2015

Much has been said and written about the differences between the RBI and the finance ministry over several issues, especially the composition of the proposed Monetary Policy Committee (although it appears that agreement has finally been reached on this issue; I understand that the MPC will have three members appointed by the government and three members of the RBI with the governor having the casting vote ).

The issue of accountability of the central bank, however, remains. As per the inflation targeting agreement reached between the RBI and the government some time ago, the RBI has to explain its failure to meet the inflation target. However, in this scheme of things, there is no accountability for output falling below potential output. There is also no accountability on issues of financial stability, exchange rate volatility, etc. On these accounts, accountability is largely a matter of the central bank preserving its reputation.

In the US, the Fed chairman appears before Congress to explain aspects of monetary policy. However, moves are afoot now to introduce legislation to formalise accountability. Bills have been mooted in Congress which would impose formal audits of the Fed's monetary policy actions by the Government Accountability Office (GAO), have the Fed adhere to formal rules for setting interest rates, such as the Taylor Rule and introduce more frequent reporting to the Congress on monetary policy. Stanley Fischer, the Vice Chairman of the Fed, has criticised the proposed moves saying that they “represent a departure from the modern governance structure that has
come to characterise the Fed and leading central banks around the
world”.

There is also a move to tap the Fed for fiscal purposes, which reminds one of the enormous increases in the transfer of surpluses from the RBI to government in recent years (it was Rs 66,000 crore in the last fiscal).

I have long argued that autonomous institutions (such as the RBI, IITs and IIMs) must also have formal mechanisms that ensure accountability to elected bodies. I, therefore, have broad sympathy for the measures proposed in the US. I am also a believer in the mechanism of Independent Audit for major government agencies, including autonomous agencies. (For instance, the CAG itself may be subject to audit). These audits should, of course, focus on broad outcomes but they must also look at internal processes- how decisions are taken, the HR issues in these agencies and large expenditure incurred.

The trouble with autonomous institutions very often is that as long as they do reasonably well in respect of one or two key outcomes- and even these are not properly defined- all else becomes irrelevant. This often reduces these institutions and agencies to the private fiefs of their heads. Accountability to parliament alone can act as a check on arbitrary exercise of power and it alone can ensure that the outcomes are in consonance with desired objectives. (Which should explain why I have long been in favour of the IIM Bill).

Coming back to the RBI, it would be useful to have the Governor appear before parliament to explain aspects of monetary policy. It would also be useful to subject the RBI an Independent Audit commissioned by Parliament. These audit reports should be placed in the public domain. It's not enough that the RBI meets the inflation target. The entire range of outcomes for which the RBI is responsible- output and unemployment, competition in banking, customer service, financial stability, exchange rates- must be subject to review. Autonomy for the RBI in monetary policy and other matters must go hand in hand with accountability to parliament.